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Amazon Under Pressure

What's with those Taco Bell commercials? Brian Lund asks if Amazon has jumped its final shark.

[Yesterday, we completed the trade announced on Wednesday. We bought 1560 shares of Millennium Pharmaceuticals (Nasdaq: MLNM) for $16.05 each, plus a $13 commission, for a total cost of $25,051.]

Have you seen Jeff Bezos, CEO of Amazon.com(Nasdaq: AMZN), on Taco Bell ads recently? Well, he's been there, hawking the new Chicken Quesadilla. Is it part of Amazon's strategy to sell everything under the sun? Or, as others have postulated, is the appearance of a CEO, whose stake in his company has fallen from over $10 billion to less than $1 billion, on ads that used to star a Chihuahua, a sign that Amazon has jumped its final shark? The market, judging from its treatment of the stock recently, seems to be leaning toward the latter interpretation.

Amazon's stock finished Wednesday at $6.35 per stub. The return on our remaining shares has fallen to just under 100%. (We've sold portions of our holding twice, netting over $35,000 on about $7,000 invested.) At one point, we had seen a gain of 2,600%. That is a big change, and not for the better.

So what does one do? As always, the question is not whether one should have bought or sold a stock, which is obvious to anyone with historical quotes, but whether to do so now. Amazon has fallen 35% this month alone, as a lot of investors concluded that now was indeed the time to sell.

The liquidity issueOne reason -- and I'm just guessing here -- is this pesky liquidity thing. For Amazon, the global economic downturn, and the near-total stoppage of business for several days earlier this month, could hardly have come at a worse time. The company has maintained for a year that it will reach pro-forma operating profitability in the fourth quarter of this year. If it misses, it won't just be a public-relations loss. It may mean that the company won't be able to fund operations in the first quarter of 2002.

For some time, Amazon has lived on delicately balanced working capital, paying past bills with current revenue. When that revenue dries up, the bills start eating at cash. The company predicted on July 23 that it would have $600 million in cash after the third quarter (which ends Sunday) on about $650 million in sales, but it's a safe bet that sales won't be as high as expected. Cash will probably come in south of the $600 million target.

But the cash balance isn't the whole story. Amazon's working capital (current assets - current liabilities) has been steadily shrinking for some time:

Even without substantial business stoppages, Amazon's net liquidity was diminishing at a rapid rate. This quarter's problems may add just enough additional damage to liquidity to push it into the negative. That won't be the end of the world -- Amazon can operate with negative working capital, so long as sales pick up in the holiday season and creditors don't squeeze the company too hard for payments.

I don't think that a liquidity crisis will occur this year, since creditors are not any more eager to see Amazon default on payments than Amazon is. But even if Amazon achieves pro-forma operating profitability in Q4, it most likely won't in Q1 2002. That quarter has traditionally been when Amazon suffers the cash hangover from the Q4 sales bonanza. If the bills are high and the cash balance has suffered from a recession for the past couple of quarters, there could be a liquidity crisis at Amazon, which has no line of credit and little access to the equity and bond markets.

Amazon's proactive approachI'm not predicting that will happen. We need at least to see the third-quarter numbers before drawing up that kind of scenario. Besides, the company has been working its tail off over the last year to avoid this eventuality. Amazon has continued to partner with major retailers, in order to expand offerings without increasing expenses significantly.

This quarter, the company opened its computer store, but Amazon does not carry the inventory. Instead, it acts as a shopping platform for original equipment manufacturers (OEMs) like IBM(NYSE: IBM). The companies will coordinate on shipping, so the bearer of the costs is uncertain, but Amazon will take title of the computer before it reaches the customer, which means it will be responsible for subsequent customer service. This is essentially the same arrangement that Amazon has with OEMs in its cell phone store, but differs slightly from its deal with Toys 'R' Us(NYSE: TOY).

Amazon also announced that it will partner withCircuit City(NYSE: CC) to expand its electronics section and offer in-store pickup at Circuit City locations. In addition, Amazon and Target(NYSE: TGT) teamed up to offer thousands of items through Amazon's platform, with Target taking the inventory risk and Amazon getting a per-unit fee and annual fixed fees. Most recently, Amazon opened an online travel store with Expedia(Nasdaq: EXPE) as the main partner.

These deals reduce the business risk and increase the scope of the product offerings at Amazon, but they also put a ceiling on profitability. Amazon may run the businesses profitably, but it will only receive a small slice of each transaction. It will be much more difficult to drive income higher when profits are shared with multiple partners. This is another reason for the sell off; even if there is no liquidity problem, the future profitability of the company is more limited.

Still, Amazon's main concern now is simply profitability -- it can't afford to look too far into the future. Partnering across multiple channels is the fast track to that end, and Amazon is running for its life. After the third-quarter announcement, we'll take stock of how it's doing.

Brian Lund continues to shop from Amazon, where he hopes to find airfares that rival what he can get from Priceline. He owns none of the stocks mentioned, but he does still own stocks. The Motley Fool is investors writing for investors.